Stanford GSB Sloan Study Notes, Week 4 (24), Winter quarter
The relative (& temporary, I’m sure) breather on reading volume this week left some much awaited time to deal with things out of the classroom: we’ve gotten over the home stretch in our core marketing course with some brand audits and presentations, on Tesla Model S. And it was even more fun to work with my MBA-mixed study groups for venture financing and business planning.
My highlight of the week was doubling the Estonian population on campus when Steve came to join our Sloan class for an evening lecture and smaller breakfast to discuss the most inspiring trends he sees as an investor (no separate notes – but see notes from the Science panel at the Intersection Event for a hint on his direction).
And I even got out of campus for a bit: to a fun chat between Eric Ries and Marc Andreessen at A16Z office on the Lean Startup movement and diversity issues in the valley. Highland Capital Partners threw a GSB mixer at the legendary Old Pro. I was also lucky to have two different insightful conversations with a physicist (one turned VC, the other a space entrepreneur, as it is customary here) in one week, on maximising impact. I am grateful for weeks like this.
Covered in this issue:
- State of Space Tourism in 2013
- Risk & Return – was it sensible for Airbus to build the A380?
- Structuring financing deals and more terms sheets
- Building an eCommerce firm in Russia
- Writing a business plan and pitching to VC partner meeting
- Advanced body language tips to presenters
- More guests & speakers from Virgin Galactic, XCOR Aerospace, Mohr Davidov Ventures, Wikimart, DeRemate, Wealthfront, Exploramed, Bare Escentuals…
Space Entrepreneurship Forum
Full agenda is here, but I sadly only made it to one session between classes:
- There are a critical mass of people on this planet who want to get off this planet
- Since Gagarin, 528 people have been in space. NASA, Russia, China increment in 5’s. Private sector will in X-s. Virgin alone has 570 reservations today.
- Current private spacecraft: 100-s on man-years to build, 10,000-s of man-hours to touch up between flights
- Virgin SpaceShip 2 mothership launches the rocket from 15km to 110km altitude, 1.5-2h total trip, lands on the same runway it took off from
- Side-effect of the tech developed for space tourism: reusable means for small payload delivery. Single-digit million bill for 500 pounds (vs $50M for large rocket). A first year space research student will be able to design an outer space experiment and get the results back before the end of year 1.
- XCOR Lynx to do a suborbital trip, land, refuel, do the checklist and go again 4 times a day. 6-7 minutes of weightlessness. $95k/flight.
- Flight test program this summer. Doing a trip to space a perk for every employee.
- Key optimisations: reutilisation, piston pumps, footprint (4 crew + pilot) key optimisations to get cost down – 35% net margin to be attractive to VC.
- The lowering cost of getting payloads up is the infrastructure, creating a golden era of VC investments in companies whose business rely on that.
- 1980 US had 100% marketshare of payload delivery launches market. Today 0% – only US government and local satellites that have other reasons to use domestic service, not competitive for any international customers.
- Low-Earth orbit as a proxy: deliver components up and assemble them in space for longer trips (Moon, Mars..)
- Daily satellite imaging of entire Earth: what is the value of counting every single car in every single shopping mall parking lot to a hedge fund manager making consumer confidence bets?
- to be able to say “I was the first Estonian in space” is the ultimate chat line in a bar (pointed out by Will, not just Steve :))
- Axe Apollo campaign
- In 1960s people compared the safety records of airlines before buying a ticket. Spaceflights will start with the same emphasis.
- Pre-flight training/preparation is more effective in a small dynamic aircraft in full spacesuit than just in a centrifuge.
- It used to be that you need terrestrial use cases to build investable space companies. (For ex: anything advancement related to recycling on Earth would have a maximum need in space). Now that you can get to a sensible milestones in space for $10-15M, that is not a necessity any more.
FINANCE 229: Sloan: Core Finance (Strebulaev)
Case: Should Airbus create the A3XX jumbo jet?
- Key strategic finance question: “how does the success / failure of this project (no matter what NPV) impact the rest of this company” – empirically 40% of CFOs never ask that
- Find a variable that you are comfortable with to test a financial model, plug it in to make NPV break even. You can intuitively see if the variable at this level is realistic (e.g plugging in a break-even number of planes in an Airbus projection, it shouldn’t exceed the full plane market size estimates)
- Asset beta <1 means the business is counter-cyclical
- Accounting for any synergies, you should adjust your cash flows, rather than change your cost of capital or other inputs. And the opposite: never adjust for risk in cash flows, but in cost of capital (avoids double counting among other things)
- Cost of capital should be for a comparable project, segment or geography not comparable firm. For ex, if a utility decides to build a nuclear reactor, the beta should come from comparable nuclear projects/firms, not utilities.
- For a second market entrant it is tempting to model their profitability on the existing player. Pitfall: competition is the strongest lever to bring operating margins down!
- Include scenarios derived from potential response from competitors in your financial modelling. How likely is the scenario where they do nothing?
Risk & Return
- Alternative measures of downside risk: semivariance (variance of losses only), tail loss (the expected loss in worst x% of outcomes)
- Compounded return (CAGR) is always below average return. The difference grows with the volatility of annual returns (an is typically about a half of variance of returns).
- CAGR works better for historic, long-term & comparisons. Averages for estimating expected returns over future horizon based on the past performance.
- Beta=0 means “perfectly diversifiable”
- In developed markets (US), correlation between 100 random stocks falls to ~20% and stays around that level also at 1000 stocks. (Systematic risk)
- Correlation between stock markets globally has increased over last 50 years along with globalisation. UK-US 0.3 -> 0.95 (virtually no diversification any more).
- Example: volatility in Japan=16%, US=10%. Correlation 35%. If diversifying just 80% in US / 20% in Japan -> portfolio volatility=9.6%
FINANCE 373: Entrepreneurial Finance (Korteweg)
VC Valuation Method
- VC method: Ignore intermediate cashflows (too uncertain), derive exit value from multiple and discount back at 20-80% (reflecting investors required return). Basically using DCF (discounted cash flows), but only with a few estimable inputs – good enough approximation. This is a game of % stakes, not per share prices, numbers of shares – which can be derived later.
- Example: Investing 10M into a company with $225 predicted exit in 4 years, requiring 40% IRR
- $10M * (1 + 40%)^4 years = $38.24M VC share of exit
- That requires 38.24 / 225 = 17.1% stake
- Post-money valuation currently, if $10M / 17% = $58.6M
- Pre-money: $58.6M – $10M = 48.6M
- Treat multi-round calculations as real options: figure out the later ones and move back to today
- If there is a $12M new round in 2 years, that VC would want: $12M * (1+30%)^2 / $225M = 9% in a round with post-money value of $12M / 9% = $133M
- The first VC now needs a larger share than 17% in initial round, to still get the expected return after further dilution on the way.
- The fraction the first VC gets is a fraction of the dilution-adjusted exit value: $225M * (1 – 9%) = $205M. Replacing it in the original formula: $10M * (1+40%)^4 / $205 = 18.8%
- This way, the future round dilution lowers the pre-money valuation of the company today: ($10M / 18.8%) – $10M = $43.3M (was: $48.6M)
- Why are VC discount rates high (35-80%)?
- Illiquidity premium (15..30% discount relative to comparable public companies)
- Compensation for non-financial value brought to the table
- Forecasts are predictably optimistic: if success rate of the entire company is 33%, a VC rate of 60% is equivalent to expected DCF rate of 20%
- Justifiable discount rates decline over rounds (seed -> A/B/C… -> bridge -> IPO) as these risks get mitigated
- Employee options pool dilutes the founders (and seed stage angels, etc), not the VC in the current round, EVEN when the language suggests “25% of post-money valuation”. Also lowers the notated share price.
- Key distinction between preferred stock and debt: you can’t force a company into bankruptcy if they don’t pay dividends
- Trust takes three years of consistent behaviour to build and five seconds to destruct.
- Experienced lawyer in Valley has done 150 IPOs, 1000s of venture deals. Going to VC the strengths are people & relationships (coming from service business) and deductive thinking (many parallels to how engineers think).
- First round financing terms will follow the company for life. When a rocket ship is standing on the launch platform, a 1 degree difference in angle can define if it goes to Jupiter or Moon.
- Pipeline: 1500 business plans / year (250 working days) -> Quick screen down to 150 meetings a year -> 15 go into due diligence -> 2 completed deals. 1:750 odds are similar to going to NBA if you’ve already played college basketball.
- Breaking through noise: unfair advantage, relationships, uncommon insight (aha!), fitting right into the thesis
- Triangulation strategy: how can you connect to the particular individual partner from 3 different angles
- Companies are vehicles in which relationships are transported. If a vehicle breaks down (and most of them do), a healthy relationship can continue in the next one.
- Biggest value lawyers can add is to bring together the sides’ expectations of the dark places neither of them want to go to.
- Deal complexity masks (and signals) the lack of trust. Despite all of the fancy language, the largest part of potential economic benefits are and should be reaped by the simplest and lowest order equity: common stock
- Most VC deals are 60-40 setups, where 90% of the time goes into negotiation who controls the middle 20 points. As a side-effect this explains why unaffiliated third party owners and spinoffs, etc don’t work well – the wedge for them is about 10% before physics kicks in.
- In early rounds the entrepreneur should present their business and entertain bids (term sheets) from VCs. In a C-round you expect the business to present the initial terms.
- When predicting the need for future rounds, take the entrepreneur’s business plan after the first attempts to bring it back to earth and then multiply the cash needs he thinks by 1.5..2X
- Entrepreneurs should put their bottom-up options pool plan on the table before the term sheet, based on key hires needed in 18 months
- Advocate for a 2-2-1 board structure (founders-vv-independent), where founders get to nominate the independent. Observer seats are often handed out as candy, but should be given more thought (if you let a corporate partner to observe for a small investment, you’ll never really be able to discuss that partnership with your board). 0.25% of stock over four years normal comp for board members. Be greedy about board seats.
- There is a school of VCs who say that as round C is much more of a benefactor from any potential ratchets (the likelihood of down round from their valuation is higher than in earlier round), they don’t even include anti-dilution terms in A-round
- There are differences in East Coast and West Coast “standard terms” – more nuanced financial engineering in first
- Conversion threshold for IPO proceeds (not just price) are important, because you want to be sure there is really a liquid market out there before you convert. (at a $500M valuation, taking just $20M public wouldn’t give you that)
- Deals are organic creatures.
- Contractual impossibility theorem: there exists no perfect deal. Perceptions of “good or bad” will change over time along with changes in people, opportunity, context.
- Value is determined by the interaction of three major ingredients: cash, risk and time. Financial decisions can create, destroy or transfer value.
- Alternative way to calculate required VC equity share (calculated above via discounting to present value) is to just bring forward initial investment at expected return and look at the ending value at exit.
- Standard deviation of NPV between different scenarios is an important indicator of risk distribution between parties. Very easy to construct structures (with preferred and participating stock, etc) where despite the identical initial equity shares, the entire deviation between good and bad outcomes will be on entrepreneurs side. Hurdles, staging of investments, etc are just variations in the overall theme of non-proportional distribution of risk.
- Valuing an option to abandon. In case of staged investments, option to re-value or option to increase committed capital are “soft” alternatives to fully abandoning a venture when performance changes towards plans.
- You can think of an employment contract as employee is selling a call and put option to the employer simultaneously:
- Employer has acquired the right to employ this person for the period of contract, and a right to fire (and keep from competing)
- Employee has acquired the right to participate in the increased value & profits (cash, bonuses, incentives). She also retains the option to quit and do something else.
- Value of the contract is the sum of these parts: value of base salary + value of option for bonuses – value of option to company to fire – option to enforce any non-compete clauses.
- Change in incentives can be explained with the overall value of these options: for example a manager deeply “in the money” with bonus options can become more risk averse in which projects they undertake.
- Earn-out contracts are very risky because of the uncertainty of where to set the trigger for additional payments. If management doesn’t hit them later, they get demotivated and/or are incentivised to delay investments, (legally) fiddle with spend and accounting. If they over deliver, they feel they should deserve more incentives, but only ones available are perks, extraordinary bonuses or relaxed working environment – all non-performance based ones that do not benefit the company.
- Endless supply of popular incentive contracts with little positive incentive to increase value:
- Percent-increase based systems. Punish for extraordinary profits and motivate to keep the first year base low.
- Revenue-bsaed systems. Ignore the lack of correlation between revenue and value.
- Group-based systems distributing across irrelevant (or too large) groups and removing individual incentives.
- Zero-sym systems. Sales rep commissions and competitions discourage co-operation.
- Hay system for big corporate salary setting. Bases compensation on how much staff & budget you control – rewards excessive consumption of resources & empire building.
- Common alignment mechanism in leveraged buy-outs: management buys “strips” of every kind of financing mechanism used: common stock, preferred stock, subordinated convertible debt… (except senior bank debt, by necessity)
- We believe we know what debt is and what it isn’t. However, when a company gets into financial difficulty, debt starts to behave a lot more like equity. It is essential to discard arbitrary notions of particular instruments when designing deals that survive both good and bad scenarios.
Reading: Deal Structure and Deal Terms (Roberts, Stevenson 2005)
- Entrepreneur typically has so little (tangible contributions) to start with she can usually only give up a claim on future value. Typically can maximise her return by selling to those who demand the lowest return, which typically means: those who perceive the lowest risk.
- Free cash flows, Tax consequences (e.g tax credit on early losses) and Terminal value are worth breaking out as a separate positive cash-flows. Depending on priorities, different financing sources could see value in specific ones of them separately, not just the entire company as an aggregate – helping you to structure a better transaction. For example:
- Risk-averse wealthy individual in high tax bracket might place value on tax benefits, even in worst case scenarios these can reduce their overall tax portfolio
- A bank looking at just operating cash flows, can construct a loan where interest expenses can be covered even by “safe-bet” low-end scenario operational cash flows, with the principal re-payment timed with terminal value.
- Different vehicles (general partnership, limited partnership, LLC, corporation..) differ notably on how precisely this break-down of cash flows can be distributed. Limited partnerships can agree to virtually any distribution of cash flows and profits between partners, as long as it is done in advance – whereas losses are usually distributed in proportion to capital provided.
Reading: Stanford Emerging Entrepreneurs Term Sheet Exercise 2007
- Many good Term Sheets-related posts on the blog of Brad Feld (Foundry Group)
- More reading on Term Sheets:
- Ask the VC
- Venture Hacks: Term Sheet Hacks, Building a Cap Table
- Annotated Term Sheet
- Guide to Stock Options
- Ask the Wizard (an Entrepreneur’s blog about Term Sheets):
- Fenwick and West Quarterly Survey of Silicon Valley Deal Terms
- National Venture Capital Association Model Term Sheet and Financing Documents
- Book: Engineering Your Start-Up: A Guide for the High-Tech Entrepreneur by Michael L. Baird, 2003
- Trick: share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to calculate with post-money numbers. As it is so easy to convert between pre/post – start with the better base.
- Investors get either the liquidation preference and participation amounts (if any) OR what they would get on a fully converted common holding, at their election; not both. (That said, in the fully participating case, the participation amount is equal to the fully converted common holding amount.)
- Logic that gave birth to drag-along clauses: “dissenters rights” or “appraisal rights” permit a shareholder to object to the transaction and require the company to conduct an appraisal of the fair market value of the shares and cash out the shareholder’s stock. Even a single shareholder exercising dissenters’ rights can delay the closing of a deal, and many M&A agreements will allow the buyer to back out of the deal if dissenters’ rights are exercised by holders of greater than 5-10% of the outstanding shares. Drag-along forces minority holders to go along with majority preferred stock holders vote on sale. Can get nasty for founders should this exit be below the liquidation preferences!
- Pay-to-play provision: investor must keep participating pro rata in future financings in order to not have his preferred stock converted to common stock in the company. Note that, if enacted, this would reduce liquidation preferences for non-participating investors.
- Redemption rights (that company buys back preferred stock after certain horizon comes without exit) aren’t usually pragmatic: an unsellable company that is going sideways usually doesn’t have cash to pay for them anyway.
- Look carefully at the closing conditions of the term sheet – tends to be overlooked as it seems a “few additional nuances”. Are these terms even pending the VC partners approval? Are non-shop clauses timed or open? If founders employment contracts are a pre-requisite to closing, what are the terms there?
FINANCE 385: Angel & VC Investments (Strebulaev)
- Whatever you have in your A-round terms, your B & C round investors likely want to keep. So you should look at liquidation preference multiples and anti-dilution protections in the potential context of future valuations, not just current ones.
- To have a clear argument when negotiating the option pool down, build a bottom-up “equity budget” for the outstanding pipeline of key hires to be made.
- A common mechanism to let founders take some cash off the table in later rounds: founder sells $1M of common back to the company, who in turn issues equivalent preferred stock to investors.
- Typical employee vesting in Valley: 1 year cliff + monthly vesting over 3 years. For founders who have been working on the company 6-18 months, common to accelerate this by a year (no cliff, 25% now + monthly vesting over 3 years).
- Easier to negotiate how much you get up front, than getting the entire schedule shorter (suspicious: are you not committed enough to stay?)
- When a founder is kicked out at 50% vesting, common to get 6-12 months more accelerated as compensation.
- Common stock valuation (for employee option pricing) in early rounds often 10% of preferred stock – the more mature, the closer the price later.
- When the term sheet is silent on some issue, don’t assume it is beneficial for you – but ask. Ex: If no vesting explicitly mentioned, doesn’t mean founders get stock now. Also, look out for catch-alls, “other terms per industry standard,” “… as in previous terms”
- Founder vesting does not impact the voting rights of all their shares. Yet, board control matters more than ownership control.
- A simple term sheet will turn into 5-6 different legal documents. Many founder vesting / firing compensation related things should go in a separate employment contract.
- Single trigger & double trigger vesting for founders – will there be full acceleration in vesting on change of control, or for another event after the acquisition?
- Is there an incentive for key people to stay there after getting bought? If not, the company is much less attractive for M&A.
- Any good VP negotiating their package will ask the terms “VC has”. So when founder gets themselves a single trigger for 100% early on, hard to hire his team in fair and transparent way without messing the structure up.
- Throwing out a term sheet at 10-20% premium valuation to the market price (with supporting preference terms) could be a short-term strategy: if you believe everything will eventually come down to the market price, you can sit back and watch how a competing VC tries to get the startup there and becomes the “bad guy”
- Board disagreements and board dysfunction are very different things, but can get sometimes confused.
- Never pass on a chance to negotiate with a reputable VC firm – best way to learn about each other and you can not have a worse outcome than just turning their term sheet down.
- eCommerce is about three things:
- Selling at the right margin & price
- Charging users and actually getting money from them
- Delivering the goods
- At the core, these three things are very similar between US and emerging markets, BUT the actual execution is very different (for example: do you need to change the common standards for courier firms? do you need to create your own e-payment company?)
- In Latin America – take the biggest market first and you get 50% of market share in the total region which is a much better platform to expand into smaller markets
- There might be more friction to start in emerging markets, but when you start getting momentum you are virtually unstoppable
STRAMGT 354: Entrepreneurship & Venture Capital (Wendell)
Unfortunately can not publish my notes from (fantastic) class discussions – there is a no-blogging policy to protect honest conversations and especially the guests.
- Guest: Andy Rachleff (Wealthfront; Benchmark co-founder): lecture on writing a business plan
- Guest: Josh Makower (Exploramed, Acclarent): recreating the pitch for Exploramed incubation NC1 (a medical device company that became Acclarent with $800M exit in 5 years)
MKTG 249 : Re-Imaging Marketing: The Power of Stories (Aaker)
- Managers deliver information, leaders deliver a message
- Parachute into the middle of your story, without preambles. Having the audience get lost for a moment is fine, they are motivated to catch up.
- Eye contact with audience: one person, one thought. With a key sentence with a triplet: eye contact 3 people, with pauses. Not just washing over a group or staying stuck on one friend in audience for a while.
- Spending 3 minutes of a 4 minute speech is fine, if that buys you the credibility and likability to drive your main message/advice home in last 25% of time.
- Amy Cuddy: TED talk on presence and body language
For more posts on the Stanford GSB Sloan life – see the table of contents here.